Venture Capital - a largely misunderstood term in India

Have idea? Will seek venture capital. This seems to be the mindset of many Indian entrepreneurs seeking venture capital in India today. Over the last few years, we have seen plans from entrepreneurs looking to start a restaurant, a coaching class, a web 2.0 project, a power plant, a budget hotel, a boating company, a travel agency, a pre school, a real estate brokerage, a jewellery shop, a nursing home, a dental clinic, etc. Many of these ideas can translate into successful businesses. However, they may not be suitable for venture capital.

What many entrepreneurs haven't understood is that Venture Capital is also a business at the end of the day. Venture Capital funds have a responsibility to its investors to maximize the returns on capital invested. The investors in the venture capital fund have chosen to invest in this asset class vis-a-vis other asset classes like public stocks, later stage private equity, with the expectation that it is a high risk righ reward asset class. Given the inordinate risk that a venture capital fund takes when backing an entrepreneur with a new idea, it is only fair that the fund expects a disproportionate return on that investment. Chances are that several of the investments may not yield the returns expected, so therefore it is even more important to be disciplined about the return expectation as the investments that do provide the expected returns need to make up for the ones that don't in order to be able to generate expected high returns for the investors on this high risk asset class.

Therefore when a venture capital fund evaluates a new business idea, it is looking for the possibilty of a "super normal" return. Many businesses don't pass that filter as they are typical linear growth cash generating businesses that most entrepreneurs think of. And therefore they have to turn down an investment proposal of an entrepreneur who has a perfectly viable business plan.

As an ex-entrepreneur, I empathise with these entrepreneurs as they have entrepreneurial dreams and are seeking start up capital to get their venture off the ground. What India needs is more angel/seed investors that are investing their own monies and are willing to help these entrepreneurs get started without the expectation of a super normal return. Typically in India, a family member or relative would provide the start up capital to another member in the family to start a business. What is important that is that start up capital is available beyond the family so that first generation entrepreneurs who could otherwise not dream of starting a company can now do so with this seed investment available.

Venture investing in education in India

Every entrepreneur I meet in the pre school and vocational training space include k-12 schools in their future business plan. One also keeps hearing of business families opening schools and universities across the country. When I recently heard that an entrepreneur who was selling sweets in North India decided to open a university with the spare cash and land available, I asked myself the question "Is this a bubble?"

While there is no argument that education is a big need in the country, I am not sure if there is really an opportunity for a venture capital firm to invest in this sector. The reasons are the following :

1. Teacher dependency. Attracting and retaining talented teaching faculty is not a trivial task. Scaling faculty across locations is even more of a challenge. I remember when I went to school, not evey faculty member was top notch. If a single school cannot maintain quality across faculty, how do you scale this to different classes and geographies?
2. Capital intensity - Purchase of land and/or building/leasing of property can be suck up capital. If the amount of capital is high at the outset, then it defeats the venture capital model of low capital-high return.
3. Regulatory environment - Certain laws prevent investors from investing in the educational institutes. Investors try and work around this by investing in a management company. There is inherent risk in that model as the school that gives the teaching contract to the management company could potentially reneg on that.
4. Lack of gauranteed jobs - Given the plethora of universities and vocational institutes cropping up, there is pressure to fill seats which sometimes dilutes the quality of candidates admitted. Many of these students who graduate cannot get placed as they don't meet the quality criteria of the employer. In the vocational training sector, many jobs don't require formal education/diplomas unlike the western world (ie. plumber, carpenter, courier, etc) and hence make these institutes less viable.

Be careful before investing in a startup in India with no strong leadership

Many times, I have heard VCs in the US talk about investing in a great product or concept without a strong CEO. Typically a bunch of engineers build a great product that can change the world, but there is no management leadership within the founding team to build a business around the product. In such a situation, a VC invests in the company and brings on an entrepreneurial CEO who can run a very young company.

Given the risk taking psyche and the robust entrepreneurial ecosystem in the US, hiring a professional management that can successfully lead a startup is possible. However, this is not as easily done in India for several reasons :

1. The risk taking ability amongst these managers is low. What if the company fails? The lack of a safety net in case of failure scares many potential managers from joining startups.

2. Parents, family and friends have a big influence on career decisions. Leading unknown companies are not widely accepted as a mark of success. Joining a Mckinsey or Citibank is looked more more favorably than joining an unknown small company.

3. Cash is more important than stock to many of these managers as they have to look after not only the spouse (who typically doesn't work) and children but also the parents and in many cases siblings as well. Typically startups don't offer the renumeration that can sustain these obligations.

4. Many of the managers are not trained as entrepreneurs. They may be bright, but they are not comfortable with selling unproven concepts to customers, hiring top talent to an unknown company, thinking out of the box on pricing, promotion, processes, etc. So even if you are able to convince a professional manager to join the startup, the chances of being able to successfully execute during the early days of the company is low.

As the entrepreneurial ecosystem builds over the next several years as more and more startups get funded, hiring strong entrepreneurial leadership into a start up will become easier. However, for now, I would caution any investor that is looking to invest early stage with no strong leader who can run the company in its early years to think twice before investing.

Investing in early stage retail is not as easy as it seems

India is a nation of shopkeepers. In a growing consumption led economy, it would seem very logical for a venture capital fund to look at investing in the retail sector. I hear a lot of VCs talk about how they would like to invest in businesses that are consumer focused and retail in particular. There are many good entrepreneurs selling services and products via retail in India and it is very tempting to believe that if they could only replicate thier initial success across a few stores nationwide, a large enterprise can be created. I believe there are several challenges in the sector, especially in India, that raises questions on whether extraordinary returns are possible in a 5-7 year timeframe for a Venture Capital investor.

Some of the salient challenges for a VC are :

1. Capital Intensity - Rentals in tier 1 towns in the best locations are still relatively expensive compared to most parts of the world. Annual rental deposits, inventory, marketing are all costs that can multiply as you scale. The company may need to raise working capital debt which further burdens the companies cash flows.

3. Lack of Brand Loyalty - The Indian consumer is very value oriented. He or she will shop where there is better value. Brand loyalty is limited.

4. Heterogenous Markets - India is a conglomeration of states with different laws, languages, cultures. To be able to scale across states requires local market knowledge and relationships which can take time to build. There are many cases where a product or service has been successful in one city but it has taken years to crack another location within the country.

5. Inefficient Labor - While labor maybe cost effective, there can be a challenge in finding productive, honest pool of self starters (executives and managers) that can help the company scale across the country.

While I am sure that there could be some unique opportunites that could counter the challenges above, one needs to be cautious about investing in early stage retail ventures if you are expecting rapid growth in a relatively shorter time frame (5-7 years). If an investor has a longer time horizon ( 8-10 years at least), then it may be more attractive.

Slumdog Millionaire = Investing in Indian Technology Ventures

Recently, I had the privilege of sitting next to the cast and crew of Slumdog Millionaire on a Mumbai- Delhi flight. It was interesting to learn about how British Screenwriter, Simon Beaufoy came up with an original script that was an adaptation of a book by an Indian author and British Director, Danny Boyle made a film based on that script using largely Indian cast and crew. A non Indian director and screenwriter had the global mindset, key relationships, access to capital, and the agility and smarts to leverage Indian talent where appropriate to create a global runaway success.

Many of the technology product companies that are being financed by Venture Capital firms in India today have similar team characteristics to Slumdog. An Indian or Non Indian entrepreneur that resides outside India or has recently relocated to India, with a global mindset and key relationships worldwide , leverages Indian talent to produce a globally successful product. Nexus India Capital has several companies of this nature in its portfolio - Kirusa (designed in New Jersey, developed in Bangalore), Pubmatic (designed in San Franscisco, developed in Pune), DimDim (designed in Boston, developed in Hyderabad).

Both film making and technology development are huge industries in India where there is a lot of mid and junior level talent that is available to execute projects. However in both these sectors, a critical mass of globally focused entrepreneurs doesn't seem to exist in India today. While we hope that this will change in the future, for now it seems like the mantra for globally success in film and technology will largely continue to be "designed outside India and developed in India."